Lump Sum or Annuity: Which Should You Choose at Retirement?
by Rande Spiegelman
Does your employer offer a traditional defined-benefit pension plan that guarantees you a monthly pension payment for life?
If so, congratulations are in order—such plans are becoming scarce these days. The trend toward 401(k)s, 403(b)s and other defined-contribution plans means that more and more workers must rely on their own savings and investments to supplement their retirement income.
However, with a defined-benefit plan, you’ll likely face a challenging choice at retirement: whether to take a qualified one-time lump-sum payout—which can be rolled over directly into a traditional IRA—or to receive a monthly annuity payment for the rest of your life or, in some cases, even longer.
The decision becomes even more perplexing when your annuity payout options include:
- Single life payment. This is usually the highest monthly amount.
- Single life with term certain. You receive a little less each month, but if you die before the specified term is over, payments continue to your beneficiaries for a preset number of years.
- 50% joint and survivor. You settle for a lower monthly payment to make sure your surviving spouse gets monthly payments for his or her life that are equal to 50% of your original annuity.
- 100% joint and survivor. You get an even lower monthly payment but, in return, your surviving spouse gets 100% of your annuity in monthly payments for his or her life.
Your choice can have major financial implications, so it’s a good idea to consult with a professional. But here are some important factors to consider as you work your way toward a decision.
Life Expectancy
The simplest analysis compares the monthly annuity payment offered to what you could generate yourself by investing the lump sum at a similar level of risk. Key to this analysis is an assumption about your life expectancy. As a general rule, those people with good reason to believe they’ll live well beyond the average life expectancy will likely find the annuity option more attractive, while those who don’t expect to live beyond the average may find more benefit from the lump-sum option. There are many other factors to consider, of course, and we’ll get to those a little later. For now, let’s talk about life expectancy.
Imagine that at age 65 your company offers you a single life annuity of $2,000 per month for life or a lump-sum payment of $300,000. At first blush you might think the annuity is the clear winner, since $24,000 per year ($2,000 × 12 months) amounts to an annual rate of 8% on $300,000 ($24,000 ÷ $300,000 = 8%), and 8% is hard to get without taking on significant risk.
In order to do an apples-to-apples comparison, however, you need to keep in mind that the annuity takes a total return approach (meaning that it assumes you will use both principal and interest during retirement, leaving a zero balance) with built-in assumptions about how long you will live.
If you assume a life expectancy of 18 more years at age 65, then the annuity’s internal rate of return is really only 4.16%. In other words, if you drew down $24,000 per year in both interest and principal on your $300,000 lump sum, you’d only need to earn an annual return of 4.16% to make it last for 18 years. In fact, the $300,000 would last 12½ years even with a 0% return ($300,000 ÷ $24,000 = 12.5).
Of course, the longer you live beyond your actuarial life expectancy, the better the annuity deal becomes. You would also have the convenience of a hassle-free monthly check. For example, assuming you receive a check for $2,000 at the beginning of each month and live 25 years to age 90, your annual compounded rate of return would be 6.61%. And if you live 30 years, to age 95, the annuity’s yield to maturity jumps to 7.31%—not a bad rate when compared to current high-quality bond yields of similar maturity.
Obviously, if you chose a payout based on your own life expectancy with no survivor benefits and you died after the first year, it would be a pretty good deal for the insurance company.
Other Factors: Income Needs, Health, Taxes and More
Here are some additional factors to consider.
Current income needs
If you already have sufficient sources of retirement income (a large portfolio, Social Security, other income, etc.), an annuity may be less attractive. And, because you wouldn’t necessarily need to tap the lump sum for current expenses, you could leave it to grow for future use or include it in your gift and estate program.
Health
The longer you live, the better off you are with the annuity. If you believe your life expectancy may be below average, a lump sum becomes more attractive. (If you’re married, you’ll want to take your spouse’s potential longevity into account as well.)
Remember, by choosing an annuity, you’re trading an asset for the promise of lifetime cash flow. By choosing the lump sum, you retain both the asset and the ability to generate income.
Risk
In retirement, reliability of cash flows is extremely important. There’s something to be said for a steady monthly check regardless of what’s happening in the markets.
First, make sure you’re comfortable with the credit rating of the annuity provider or pension fund. (The Pension Benefit Guaranty Corporation, or PBGC, is a federal government agency that provides protection for pension participants, but the protection is not unlimited.)
Then, consider the advantage of leaving the risk of investment performance to others rather than taking it on yourself.
Inflation
Unless the annuity payment carries a cost-of-living adjustment, you’ll lose purchasing power over time. A lump sum could be invested to include a prudent allocation of equities and TIPS (Treasury Inflation-Protected Securities) to hedge against inflation. Of course, doing so would involve taking on some market risk.
Convenience
Again, there’s something to be said for having a monthly check automatically arrive in your bank account—especially if you plan on doing things besides managing your portfolio during your retirement (such as traveling). Even a bond ladder takes some expense and effort to manage, particularly if you’re looking to generate a monthly check. You could pay a money manager to implement a total return strategy that generates income from your portfolio if you couldn’t or didn’t want to do it yourself, but that’s essentially what you’re doing with a fixed annuity.
Keep in mind that managing a lump sum for retirement income takes careful planning, budgeting and discipline.
Cost comparison
Managing a lump sum yourself means incurring investment costs (management fees, transaction fees, etc.). Such costs are already factored into the annuity option. It can pay to do some cost comparisons here.
You may want to shop around to see what kind of fixed annuity you could purchase from a high-quality, low-cost provider for an equivalent lump sum and compare it to what your pension plan is offering.
Taxes
If you opt for a lump-sum payout, you can roll it over to a traditional IRA and continue to defer taxes. Receiving a monthly check, by contrast, provides you with immediate taxable income. Consult your tax professional about your specific circumstances.
Gift and estate planning
Unless you choose a term certain or survivor benefit option, your annuity ceases when you die. A lump sum, however, could provide your heirs with additional resources. Be sure to factor your gift and estate planning goals into any lump sum versus annuity decision.
What About Both?
You might choose to take a lump sum and allocate a portion to a high-quality, immediate fixed annuity. Ideally, you’d annuitize as much of your essential fixed expenses as possible and use the rest of your portfolio for discretionary spending.
A reliable, fixed cash flow during your retirement years, even at a modest level, has a number of benefits. It can:
- Boost your chances of maintaining your desired standard of living,
- Help you avoid the need to liquidate assets at the worst possible time, such as during a bear market, and
- Help you to sleep better at night as you enjoy your “golden years” (especially the early years, when you’re likely to be more active).
Use a Reasonable Estimate
Be sure to use a reasonable estimate of what your lump-sum investment might earn.
We think a conservative portfolio of 20% equities, 50% bonds and 30% cash could grow 3.3% on average annually over the long term.
Double that equity allocation to 40%—a riskier portfolio—and our 20-year estimate is still just 4.2% per year, much less than the annuity’s total return in the 30-year example discussed here.
—Rande Spiegelman
Content in this article is © 2012 Charles Schwab & Co., Inc., Member SIPC. All rights reserved.
Discussion
Donald Moody from NC posted over 3 years ago:
Since the lump sum distribution amount is based on some internal rate of return, does the current low interest rate market argue for taking the LSD now versus annuity payments which when annuitized in the future are likely to have a higher IRR interest rate factor?
Mark Wilson from CA posted over 3 years ago:
I have this decision in the next 45 days and am thinking of rolling the lump sum into a deferred life income annuity but I have heard that since interest rates are low right now it is not a good time to choose either an immediate or deferred Annuity. I can't find an answer to sizing the benefits of waiting til interest rates rise ...which I think they will. Any rough order of magnitude way to calculate this?
J Morlock from NJ posted over 3 years ago:
I think this was a useful article that is worthy of a part 2.
It would be helpful if AAII could publish a spreadsheet to calculate the internal rare of return for an pension annuity offered by an employer so it can compared to taking a lump sum and investing it for income distribution over time. There should be a way to calculate the breakeven point - the number of years someone must live in order for the annuity payments to equal the value of lump sum invested for growth and retirement income distribution.
An annuity protects against longevity risk and eliminates the risk of having draw downs in an investment portfolio being depended upon to generate retirement income distributions. The major disadvantage of an annuity is lack of protection from inflation risk.
Potential retirees should understand that the present value of their pension is dependent on the interest rates used by their pension plan to calculate lump sums at the time they make an annuity versus lump sum election. The lump sum present value present of an annuity is maximized when interest rates are low. That's becasue a larger up front lump sum is required up to generate the annuity payments over a persons expected life. The lump sum present value of value of an annuity will decline as interest rates rise.
Rick Croote from VA posted over 3 years ago:
Omitted from consideration is the creditworthiness of the annuity provider. Just ask an AA pilot who is concerned about collecting less from the Gov't Pension Insurance Fund then what s/he otherwise might have received if AA had not gone bankrupt.
Jeff Kozimor from OR posted over 3 years ago:
Great discussion and article. J Morlock's notes are right on - well done!
The key is the longer that you may live, the better the pension annuity becomes. If you die earlier than the actuarial tables predict, you lose money. Taking the lump sum puts money in the bank and takes early death and company specific risk off the table (like American Airlines).
Another key consideration is covering essential expenses with "guaranteed" income such as a pension and social security. That means that if all hell breaks loose in financial markets (like the period we just experienced), a retiree has peace of mind that they can cover their essential expense to live. A pension for the most part, takes market risk off the table.
Mark Wilson above, leads to another strategy; given that interest rates are presently low thus providing a larger lump sum amount today, why not take the lump sum now and wait for interest rates to rise and then purchase an annuity from a low cost provider?
Robert Mann from MI posted over 3 years ago:
On what life expectancy is the lump sump calculated: employee life expectancy, combined employee-spouse life expectancy, other? Could taking a lump-sum now purchase an annuity providing greater monthly payments than a 65% survivor pension from the employer?
Jeff Kozimor from OR posted over 3 years ago:
Caveat: I am not an actuary, and for exact answers it would be best to ask the plan administrator.
Given that, most should be based on the employees age at retirement, interest rates, and life expectancy. All other options, such as a 65% survivor pension benefit or others are mathematically equivalent to the single life option. If you want a little more in one place, you give up some $$$ from the single option.
It is unknown what you can get from another annuity sponsor and you'll have to shop it. If you do, let us know! In most cases, annuity firms need to make money, especially insurance companies. It seems logical that the employer sponsor pension annuity is not out to make a lot of money charging their retires high admin fees.
Donald Burman from IL posted over 3 years ago:
A site I've run across with useful limp sum calculators is: http://www.pensionbenefits.com/calculators/
Nice thread, thanks.
Dave Gilmer from WA posted over 3 years ago:
J,
The way I calculate the IRR is with a $30 HP financial calculator, using the cash flow / IRR function, making the only reasonable assumption that you can make about your life span, and that is that you will live an "average" life, which I think right now is somewhere around 85. You can of course use any number of years for the cash flow you want, however I think this will bias your results - remember you could get hit by a bus tomorrow, so I think to assume you are better than average is to play right into the insurance companies "longevity table."
I just made this decision for myself about 9 months ago and I spent about 6 months doing my research, what it came down to for me was an analysis of my needs vs my other cash flows and IRA / Roth accounts.
The NEEDS of the retiree was not stressed much at all in this analysis and I think is the most important aspect of it. What I mean by this is everyone has income in retirement that can be broken down into areas such as NEEDS, WANTS, & LIKES. I believe it is not necessary to fund 100% of all of the above with a secure fixed income. In other words if you also have a fair sized 401k account, you probably only need to fund the NEEDS portion of your income with fixed income such as pension and SS. The rest you can fund by taking a little more risk with your 401k type money.
So most importantly decide how much fixed income you really need (considering of course that most of it may not be inflation adjusted - including SS in the future) and then work your calculations from there.
It is entirely possible that the best choice is to take the lump sum but convert say half of it to an immediate annuity (and maybe even over 2-3 years 1/3 at a time) and put the rest into a good growth index fund that will at least track the market. What I did was a variation of this, part lump sum on what was a supplemental voluntary pension, but the main income from the annuity with survivor benefits.
fd
Dave Gilmer from WA posted over 3 years ago:
As mentioned this subject probably needs a part 2.
Generally I liked the article, as I think it gave fair coverage to both Risk, and Cost comparisons of managing the lump sum yourself.
However, I disagree with the author's general rule that annuities are more attractive for those that expect to live longer. NONE of us really know whether tomorrow will be our last day or 30 years from now. The correct question to ask is for the NEEDS portion of my income do I need more fixed income.
I also don't think it is ever appropriate to annuitize 100% of your retirement savings to cover your income needs as this is just a disaster waiting to happen.